Q: If capitalism isn’t greedy, then why do some companies charge exorbitant prices for critical products like gasoline and lifesaving drugs? Aren’t they gouging to reap excessive profits?

A: Profit is a critical indicator of consumer demand and the only way to ensure that there will be a sufficient supply of anything. By the way, profit is among the smallest components of drug and oil prices.

When gasoline prices soared between 2004 and 2008, people were enraged by the profits being made by oil companies. A Gallup poll found that more Americans believed the high price of gasoline was due to oil company greed rather than to other factors, including the Middle East conflict. Politicians from California senator Barbara Boxer to then New York senator Hillary Clinton called for measures to “get tough” on “Big Oil.” Vermont senator Bernie Sanders sputtered in an editorial: “Exxon-Mobil has made more profits in the last two years than any company in the history of the world.”

Similar indignation has been directed at the pharmaceutical industry. Critics accuse drug companies of “gouging,” among other transgressions, calling for various government regulations to rein in “Big Pharma.” “Other countries don’t allow prescription drug companies to gouge their customers,” complained former Congressman Tom Allen (D-Maine).

The critics aren’t entirely wrong. Bernie Sanders is correct when he says that oil company profits were the highest in history. And it’s true, as Tom Allen suggests, that newly developed brand-name drugs can cost more in America than in other countries. The cholesterol-lowering medicine Lipitor, for instance, costs about sixty cents a pill in Paris and around four dollars in Philadelphia.

Yet these emotional accusations reflect a misunderstanding of the myriad and complex factors affecting pricing and profit. People who decry oil company profits, for example, don’t understand that a major factor driving up oil prices was the weak value of the dollar on currency markets, a result of the Federal Reserve Bank printing too many greenbacks. Also driving up prices was the high demand for oil, driven by rapid growth in India, China, and eastern and central Europe.

Both factors, of course, have little to do with profit. In nonrecessionary times, the typical net profit margin of oil companies–what they make off each dollar of revenue–is only around 8 percent. That’s far less than the profit margins of banks (over 19 percent), software companies (17 percent), and even food producers (more than 9 percent). And it’s just a little higher than the profit margin of Starbucks, which is around 7 percent.

Pharmaceutical profit margins are ordinarily around 18 percent or 19 percent, only nominally higher than those in the software industry. Yet they’re especially reasonable considering that only about one in a hundred drugs ends up on the market. Each drug that makes it must generate enough revenue to cover the development costs of the ninety-nine drugs that didn’t–as well as the cost of future drugs. And bringing a single drug to market costs a major pharmaceutical company anywhere from $800 million to $1.5 billion.

If a drug company does not come up with new, successful drugs, profits stagnate–and stock plummets. Pfizer, for example, has had a dearth of blockbuster drugs in recent years. The result: the stock had plunged over 70 percent in value between 1999 and 2008.

Yet some people believe that pharmaceutical makers and oil companies shouldn’t be allowed to make a profit–or that their profits should be limited through taxation or price controls. They don’t understand how profit functions and the role it plays in a Real World economy.

Profit does more than make some people rich by generating dividends and capital gains. It is also the way our economic system mobilizes people to provide for others. This goes beyond merely serving as an incentive: profit is a critical barometer of demand, telling producers where they should invest–or where they should cut back. It keeps supply flowing smoothly.

For example, if demand soars for, say, coffee, producers will raise their prices. And why not? Java is in greater demand and thus more valuable. So what happens? The lure of higher profits encourages producers to grow and process more. New coffee suppliers may also be enticed to enter the market. The result: supply increases.

Then something else happens: profits create competition. Higher profits bring more players into the market. To compete, producers have to slash prices. The result: profits eventually fall.

An example: Xerox, inventor of the modern photocopying machine. The enormous profits the company made with its first copiers soon attracted countless competitors, including Canon, Ricoh, and Mita (now Kyocera), to name a few. At one time only large offices could afford these machines. Today they’re so cheap that even students can afford desktop models. And not only do they copy, they scan and print, too.

Scores of other examples are provided by the electronics industry. A few years ago flat-screen TVs cost ten thousand dollars or more. Now you can get many for under five thousand dollars.

What happens when companies aren’t allowed to generate profits? No barometer exists to adjust supply to meet demand. Politicians like to think that punishing profits serves the public interest. But the Real World economic truth is that it does the opposite. You end up with shortages of essential products–and sometimes surpluses of things no one wants.

Many people today are too young to remember what happened after President Richard Nixon imposed controls on the price of oil in the 1970s. Immediate shortages of gasoline resulted, which led to gas lines. People had to fill up on given days, depending on whether they had odd- or even-numbered license plates.

Taxing profits to punish “greedy” companies doesn’t work, either. That’s because profit is a key source of the investment capital companies use to expand operations, innovate, and create jobs.

In the case of oil companies, taxes on profits destroy capital that would otherwise go toward exploration and new oil production. In 1980 President Jimmy Carter enacted the Windfall Profit Tax to punish supposedly avaricious oil companies. What happened? Domestic production plunged. With oil companies producing less, the levy generated far less for Uncle Sam than proponents had predicted. The Windfall Profit Tax was widely considered a disappointment and was eventually repealed.

Decades later, when gasoline prices skyrocketed from 2004 to mid-2008, there were no gas lines. Why? Because there were none of the kind of profit-punishing price controls imposed by President Nixon in the 1970s–something antiprofit protesters have failed to notice.

As for drugs, a major reason newly developed medications are more expensive in the United States is not because of “gouging.” It’s because drug makers charge more in this country to recover the costs of selling to Canada and European nations whose state-run health-care systems keep drug prices artificially low.

So what do Canadians and Europeans get for their “fairer” drug prices? As we will explore in chapter 7, they get fewer new medicines and treatment with older, frequently less effective drugs.

Critics say profit is merely a bribe to get businesspeople to provide products and services. Actually, profit is essential to achieving innovation and a higher standard of living.

The late renowned management guru Peter Drucker repeatedly emphasized this key, oft-ignored point: without profits, there is no capital to build the advances of the future. If you don’t have profit, you don’t get change.

Profit is not only moral. It’s essential to a healthy economy. What’s immoral is not allowing people to make it.